Year in Review: Municipal CEFs

2012 was a good year for municipal closed-end fund investors. Low short-term interest rates led to cheap leverage financing, while falling long-term municipal rates and lessening concerns over municipal credit quality led to capital appreciation.

As a result, every single municipal CEF, many of which used leverage, had positive net asset value returns for the year. Things also went well from a share price return perspective, with only one fund logging a negative return (AllianceBernstein NY Municipal Income AYN lost a paltry 0.5%). Looking past the amplified capital appreciation, the shape of the yield curve also partially influenced ubiquitous distribution cuts throughout the sector.

Income-oriented investors should note the importance of understanding these trends for the sake of future distributions. The last two weeks have been devoted to year-end reviews of taxable CEF sectors. With this in mind, let's take a closer look at the performance and major developments of the muni CEF market of 2012.

Performance

One main trend sticks out from the performance table above: 2012 paid off for riskier funds. The top 10 absolute performers all had below-average credit ratings, while eight of them had above-average leverage ratios. Similarly, eight of the 10 worst performers had either average or above-average credit ratings, while four had below-average leverage. What's more, the worst performers list is largely populated by funds that focus on intermediate- and short-term securities. Looking at the Sharpe ratios of each list (which adjusts performance for volatility, not other risk factors such as interest-rate sensitivity and credit quality), the best performers were still above-average. However, it's worth noting that four of the funds (Eaton Vance Municipal Income EVN, PIMCO Municipal IncomePMF, PIMCO Municipal Income II CommonPML, and PIMCO Municipal Income IIIPMX) had either below-average or only slightly above-average Sharpe ratios.

The other thing that sticks out is that share price returns fell short of the performance of the underlying portfolios. While the average NAV increased 15.3%, the average share price only increased 12.6%. In fact, the sector started off the year at an average 2.2% premium, winding up at a 0.2% discount.

Aside from California having appeared to dominate New York, we see some of the same trends among state funds: Three of the top five state funds had below-average credit ratings and high leverage ratios, while the worst performers were all short- or intermediate-focused funds with mostly average credit ratings and leverage ratios.